What is Passive Investing?

For some, the idea of investing conjures up images of crazed traders on the floor of an exchange.

Others think of someone in a home, sitting in front of a computer screen, desperately trying to time the exact best time to buy — and then to sell.

These images, and the idea that you have to be on top of all the market movements and news, discourage many from investing.

Not all investing is a short-term attempt to profit, though.

Indeed, many investors are passive investors, doing very little to actively manage their portfolios. Think investing in a tax-advantaged retirement account like a 401(k) or an IRA.

A passive investment doesn’t have to be all about your retirement account, though. Anyone can be a passive investor and come out just fine in the end.

Definition of Passive Investing

Basically, passive investing is a strategy that involves purchasing assets with the assumption that you will hold them for a long time.

You create an investing strategy that focuses on the long term so that you don’t need to worry about trying to time the market in a way that allows you to profit from short-term fluctuations.

A passive investor purchases assets with the understanding that, left to their own devices and without tinkering, they will grow in value and be profitable in the long run.

A passive investor doesn’t change asset allocation the moment a market crashes, or when the economy slows; instead, he or she stays the course. The idea is that the investments held in a passive portfolio will be profitable over time, and won’t be injured too much over a period of 20 or 30 years by a few years of difficulty.

It’s worth noting that passive investing can be facilitated with dollar cost averaging made through automatic investments.

The passive investor can designate a certain amount of money each month to go to different assets, and have the amount automatically deducted from his or her bank account (checking or savings) or paycheck. This automatic investing heightens the passive aspect of investing, allowing your portfolio to grow, and helping you buy more assets, without the need to do anything new month to month.

Tools of the Passive Investor

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If you want to be a passive investor, it’s important that you have the right tools, and that you understand the implications of a passive portfolio.

First of all, passive investing requires some work at the outset.

A passive portfolio requires that you do some research initially. If you aren’t going to be dumping your assets at the first sign of trouble, you need to make sure that the assets you’re investing in are solid. Research ahead of time is vital, since you will want to put your money into assets that have strong fundamentals, and that are likely to weather market setbacks relatively well.

Another important characteristic of a passive portfolio is diversity.

When you aren’t actively buying and selling, it’s important to make sure that you are diversified appropriately across different asset classes. You should also consider geographic diversity in your investments, as well as sector diversity.

With a passive portfolio, you don’t want all of your investments to be the same. Some diversity can ensure that your portfolio has limited risk exposure.

Once you understand the need for good initial research and diversity, it’s time to consider what investments you want to include in your portfolio. Some of the popular investments used by passive investors include:

Index funds: These funds track specific indexes. You can track small caps and large caps, foreign investments and domestic investments. You can also specify socially responsible index funds, and other specialized funds. There are also bond index funds that can help you add diversity. And, if all else fails, you can invest in an all-market fund that will mimic the performance of the entire stock market.

ETFs: Exchange traded funds are growing in popularity because it’s easy to buy them on the stock market. ETFs provide many of the same benefits of an index fund, basically allowing you to invest in collections. ETFs also come in currency and commodity varieties, in addition to stocks and bonds.

As you build your passive portfolio, remember that you can’t completely forget about it once you have your asset allocation set, and your automatic investments arranged.

Passive investing requires very little maintenance once you get started, but there are still activities you need to complete.

Periodically review your portfolio and tweak your asset allocation as needed, or get rid of investments with worsening fundamentals. With careful construction initially, and with periodic adjustment, you should be able to maintain a passive portfolio that performs well over time without a lot of effort on your part.

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Miranda is a freelance writer and professional blogger specializing in financial topics. Her work appears on numerous financial sites, including Wise Bread and Huffington Post. Miranda's blog is Planting Money Seeds.

The idea of sticking with your investment choices for the long term is pure gold. The primary cause of daily stock price changes is investor emotion. If you change your strategy each time Mr. Market experiences a mood shift, you are doomed.

However, it is imperative that those who are planning to stick with their choices for the long term be absolutely certain that they are making good choices. This means that Passive Investors must pay attention to price (valuations) when setting their stock allocations. That was the piece of the puzzle that was left out when the Passive Investing concept was developed (because the research showing how important it is had not yet been published).

Thanks for all the great work you do, Miranda. I think you may have the best work ethic of anyone in the Personal Finance Blogosphere.

I really like the idea of investing in index funds. They perform generally the same or even better that actively managed funds. According to a one study only 41.6% of actively-managed U.S. large funds that beat the S&P 500 in a particular year were able to beat the S&P 500 in the next year. After three years, only 9.7% of the original group was still beating the index.

Miranda great article. When I first made the career switch to becoming a financial planner and investment advisor a colleague told me that in his opinion buy and hold is a very active investment strategy. That was 15 years ago and I still agree with him. What you describe is many ways the approach that I and many of my advisor colleagues use when investing client assets. In my opinion the best approach to investing and asset allocation to first do a financial plan which will lead the investor to his/her allocation based upon their goals and risk tolerance. It is vital for folks with a number of accounts (say a 401(k), a spouse’s retirement plan, some taxable accounts, a few IRAs, etc.) to look at their allocation on a total basis accross all of these accounts. Lastly, as you said, no portfolio is set it and forget it. Investors need to review their allocation, their holdings, and their overall situation on a regular, periodic basis and adjust as needed.

Very nice article! I almost get a lot of questions/confusion about what actually constitutes passive investing. A lot of folks think that it involves picking dividend stocks or creating passive income.

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